Fake it till you make it : Stock Markets edition

Many of the entrepreneurs who eventually have a successful business will tell you that they had a secret : they faked it till they made it. It’s good advice to reinforce a positive behavior, but are the markets currently using the same technique to keep going higher?

The FED fakes it

We’ve heard for many years now that the FED plans to eventually increase its interest rates. It has been at 0% for 6 years and has increased to a small 0.5ish% end of last year. They had initially announced that they’d raise the rates 4 times in 2016. It quickly became 2. Now it’s maybe only 1 or nothing at all, who knows.

For the past couple of years, the FED has basically faked it hoping that they’ll make it. If they can convince the markets of future rate increases, they won’t create chaos when they actually raise them. Look what happened in December – January. This wasn’t expected, the markets caught a cold.

So how is the FED faking it?

First, after their meetings, they publish so-called “Dot plots”, which shows the rates in the near future that each of the board members is expecting. The average is shown with the dotted line.

How the FED plans to fake it till they make it

Second, they hope the markets believe it and price them in the stock prices. This is visible in the FED Funds Rate futures. It currently shows a 50%/50% chance of rate increase in December 2016. But only a 11% that it reaches the level the FED wants between 0.75% and 1%.

FED Funds Rate futures for Dec 2016

I’m guessing a little more faking will be necessary until they make it.

Where is this information available ?

On the FedWatch tool from the CME’s futures exchange. It tracks both the latest dot plot and the market’s estimates.

Hopefully, the FED will manage this game well and will avoid creating a market crash. Because it currently doesn’t have a great track record.

The stocks fake it too

Because stock markets believe that the future interest will remain so low for so long, it justifies high valuations. When the P/E of a stock is 25 for example, it’s the same as a yield of 100 / 25 = 4%. With bond yields so low, stock remain attractive even with a 4% yield.

So how are the stocks faking it?

First, the S&P500 has gained around 70% since late 2011 and today, which looks like a strong bull market and would signal a strong recovery. However, earnings haven’t increased a bit since then, because companies’ profits have been flat or down since Q4 2011.

Second, dividend stocks (eg. Oil & Gas) have become more attractive to yield seekers and are becoming a substitute for bond yields. Prices go up due with the stronger demand. These days 65% of stocks yield more than the 10-year bonds. For reference, it’s typically <5%.

Earnings have been flat or falling for many years now. Companies are trying hard to juice their profits with non-GAAP reporting, but it’s gone so far that the SEC has started cracking down on the widespread practice. I don’t think more faking will actually make it.

During a recent interview with Warren Buffet, someone asked if the stock market was currently overvalued. He replied “it depends on what the interest rate will be in the near future. If it’s still zero, they will indeed be cheap. If it significantly higher, they will be horribly expensive”.

Will they make it?

About a year ago, I thought that the markets had reached a high point and were ready to go down. I reduced my exposure to stocks and increased my allocation to bonds. The bond portfolio has performed as well as the stocks portion so far.

This game of ‘fake it till you make it’ can continue for a little while.

As long as bond yields keep going down and no-one believes the FED, stock valuations have the potential to keep going higher. The problem only gets worse the longer this goes on.

Janet Yellen is due to have a speech on monetary policy out of Jackson Hole this Friday.

Like the previous ones, it’s probably going to be as clear as mud. There will be lots of predictions but no clear direction. So instead of making predictions myself this time, here are a few links for you to track the indicators that are usually discussed along with the FED rate hike articles:

14 COMMENTS

Nice commentary, Nick. We’ve been waiting for those interest rate hikes for years and they’ve never come (except for the paltry 25 bps increase last December). I’m not an economist so hard for me to be critical of their decisions, but I know I’ll take any “expected” future rate hikes with a grain of salt…

While the stock market has continued its bull run, the last couple years have been basically flat (not much of a stampede by this bull…). We’ll see if our economy can gain some momentum, but nonetheless the fed seems to be basing their decisions on the global economy, not the national economy.

To be fair, the FED’s job is particularly difficult. They have financial tools at their disposal to make a difference, but they don’t have the political power to make fiscal or policy changes to make bigger changes. If they have to base their decisions on what other countries are doing, Europe, Japan and England are still easing. Emerging countries have a lot of debt denominated in USD. I’m being a bit sarcastic in the article, but this must be an awfully hard job to find the best to manage this. Hopefully this will be a smooth transition.

Nice roundup of links and sources, and No, I don’t have any I could add to that. 🙂 I know in the energy industry even 5 years ago, everyone was “waiting for interest rates to rise, and then I’ll retire” mainly because of how their plans are structured, they’d start eroding capital if interest rates started going up. Like you pointed out, no real raises there in 6 years, and except for the downturn causing some to retire, I think I’ll be out of the industry before “the great crew change” ever comes about.

Back to the FED, I believe they’re faking it, much like the Saudi’s and their chatter about freezing output. the markets hear freezing output and oil climbs $2/bbl, then of course nothing happens and they report record production for the last quarter. The FEDs are doing the same I think, just like you pointed out. They mention raising the interest rate, and minus one time where it went up a shade, it’s all been to drive the markets.

I like your analogy with the Saudis and OPEC regularly announcing a ‘production freeze’. Which never happens, but somehow the markets feel happy for a few days knowing that it could happen. In parallel, the Saudis have announced that they want to diversify away from oil by 2020, as a way to say that they don’t really need oil anymore. It’s like the FED saying that whenever another recession hits, they don’t need to have to reduce the rates, they have other tools at their disposal. Both might be true, but it’s obviously less than a sure thing.

When the ‘great crew change’ happens, we will both have changed industries!

Thanks for a really interesting analysis. The FED’s maneuvers are definitely intriguing at this point. We’ll have to see how they dig themselves out of this. Your article brings to mind the idea that the markets can stay irrational longer than you can stay solvent.

I’m sure they are doing the right thing, but I don’t know how effective this will be. Markets may be rational at this point, but it reminds me of the market in the year leading to 2000. Fundamentals didn’t matter as much then and moving into the new millenium with these hot internet stocks seemed more important. Now interest rates speak seem to dominate valuations. We’ll see what makes it become more rational again.

Isn’t it the best to read about finance in a sunny summer afternoon, outside in the garden? I’m with you on that, except when you live in Houston, you need to replace ‘summer’ with ‘fall’ or ‘spring’ 😀

That wouldn’t surprise me either. I sometimes find it hard to get to the source of the information that the news report on and I’ve compiled my own list of links over time. They can help us look at the data without the news outlet’s own interpretation.

Great, great post. I’ve read a post over on financial slacker and he convinced me pretty well that the Fed will never ever significantly raise interest rates. The government will just spend a lot of time refinancing the massive debt that they already have and I agree!

I feel that the world economy right now is on the brink of a recession. The US’s economy is on fire while the rest of the world is not and in the age of globalization, that can’t work over the long term!

When everything is connected, it’s difficult go against the tide so despite the FED’s will to hike, it may be difficult when everyone else is easing. It does feel like the economy is doing well but is fragile, with a little luck it can continue and go a long way. Do you have the link to the article you’re mentioning? I’m curious now 🙂

It is a unique investing environment that everyone is working in the moment. Should investors look at interest rates to decide if this market is expensive or not? It’s hard to say. The world will be a much saner place when interest rates reflect risk much better. History averages suggests that a reasonable dip should be coming soon – but what will cause it, and how bad it will be, who knows. The fed should increase the interest rates, but doing so would hurt a lot of developing countries and make it harder for the US to pay down its debt (not that it’s using this time to pay down debt, the debt pile continues to grow).

Good analysis Tristan, this shows just how much things are interconnected. The job reports are getting lower and lower, so the FED might be trying to time the bottom and raise the rates then to reduce the impact. There will be an impact, as you pointed out domestic but also internationally, but there’s no win-win here. Let’s see what they are planning for us and see if that matches what the markets have priced in 🙂 Thanks for sharing your thoughts !

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